What is credit card interest and how does it affect me?

Getting your first credit card is super-exciting. That small piece of plastic is a gateway to adulthood, and when used responsibly, it can be your first concrete step toward establishing sound financial habits to last a lifetime. Unfortunately, though, many teenagers and young adults don’t know enough about credit card interest when they open their first credit line (such as with a credit card) and end up deeply in debt — and quickly.

Don’t let this be you! Be sure to learn all you need to know about credit card interest and how it works before you apply for your first credit card.

What is credit card interest?

Interest on a line of credit is money the credit card issuer charges to the cardholder for borrowing money every time they use their credit card. The interest is generally set at an annual rate known as the annual percentage rate, or the APR. Credit card companies use the APR to calculate the amount of daily interest the cardholder is charged for purchases as well as the unpaid balance on the line of credit associated with the card.

Important credit card terms to know

Before learning how credit card interest is charged, you’ll need to know some basic credit card billing terms:

• A credit card billing cycle is the period of time between credit card billings. Billing cycles can range from 20 to 45 days, depending on the credit card issuer. During that time frame, any purchases, credits and interest charges will be added to or subtracted from the balance.
• When the billing cycle ends, you’ll receive your credit card statement, which will reflect  all unpaid charges and fees for this period of time.
• The statement will also highlight the payment due date, which tends to be approximately 20 days after the end of the billing cycle.
• The time frame between the end of the billing cycle and the payment due date is known as the grace period. If you neglect to pay your bill in full before the grace period ends, the outstanding balance will be subject to interest charges.

Calculating interest charges

To calculate your interest charge for a billing cycle, follow this formula:

Step 1:  Divide your APR by the number of days in a year to get your daily periodic rate, or the amount of interest your credit card issuer charges cardholders during each day of the billing cycle.

For example, if your APR is 18.5%, you’ll divide that by 365 to get your daily periodic rate of .0005%. (0.185 / 365 = .0005)

Step 2: Multiply the daily periodic rate by your average daily balance, or the balance you carry during each day of your credit card’s billing cycle, to get your daily interest charge. To find your average daily balance, look on your credit card bill. You can also determine your average daily balance by taking the sum of the balances at the end of each day in the billing cycle, and dividing that number by the total number of days in your billing cycle.

Using the numbers in the above example, if your average daily balance is $1,200, you’d multiply this number by your daily periodic rate (.0005%) to get a daily interest charge of $0.60. (0.0005 * 1,200 = 0.60)

Step 3: Multiply your daily interest charge by the number of days in your billing cycle.

Staying with the above example, if your billing cycle is 30 days, you’d multiply $0.60 by 30 to get an interest charge of $18 for this billing cycle. (0.60 * 30 = 18)

Avoid paying interest

Credit card issuers will only charge interest if you carry a balance from one month to the next. If you pay your balance in full before the grace period ends, there will be no interest charged. It’s a good idea to familiarize yourself with the payment due date on your credit card billing cycle and to set a reminder to pay your bill before it’s due whenever possible.

If you have a large outstanding balance and paying it in full at the end of the billing cycle is not possible, at the very least try to pay more than just the minimum payment each month. It’s also a good idea to avoid charging more purchases to your card if there is already an unpaid balance. Remember: A credit card purchase that is not paid off before the payment due date can mean paying for that purchase for months, or even years, to come.

Credit cards are a necessary part of life. Building a strong credit history can open the door to long-term loans and other financial opportunities, but neglecting to learn how credit card interest works can lead to a spiral of debt. Before opening your first credit card, brush up on your knowledge of how credit card interest works and how it affects you as a cardholder.